Free «The Effectiveness of Basel III» Essay Sample

The international Basel III standards are expected to establish 7 % capital plus up to 2.5 % buffer surcharge, as per requirements for the biggest multinational financial institutions depending on banks’ overall risk levels.
For about 30 U.S. banks with over $ 50 billion in assets, newly-established requirements would restrict their credits to a sole counterparty to 25 % of the regulatory capital. The largest banks are going to face even stricter limits of 10 % capital for credit exposure, for two banks with over $ 500 billion consolidated assets. The same procedure can be performed between one large bank and another prominent but nonbank financial company (Wyatt, 2011).
The additional requirements of Basel III are to increase disclosure requirements, remove Tier 3 capital, reduce Tier 2 capital, raise quantity and quality of Tier 1 capital, and introduce new capital limit system.
The Federal Reserve also proposed to establish certain triggers, which will give early warnings that a bank can face financial troubles. Such triggers would start the restriction process on growth, dividends, capital distribution, asset sales and executive compensation.
The effectiveness of Basel III is under a great doubt. Many consider Basel III just a slight improvement of Basel II. The main argument against its implementation is fierce competition among banks, which makes obvious that it will always be ‘good’ for someone to spend all the money of the system. This means that even the best rules are useless unless this regulation will be supplemented by competent and active supervision (Bhusnurmath, 2010).
The biggest failure of Basel III, however, is that it does not tackle the most noteworthy contribution of Basel II to the financial crisis, that is, the risk-weight calculations. One of the Basel II principal components was to increase the sum of capital the banks had to keep against riskier assets. Meanwhile, remarkably low-risk assets could be kept with no or extremely little capital. Moreover, risk was calculated mostly only by reference to the rating agency’s evaluation. Basel II aimed to discourage banks from lending to those companies which were under the risk of experiencing troubles with paying back. Since the risk-weighting was not changed, Basel III doubles down on the previous Basel. One outcome of Basel III could be to call banks to rise their lending at the zero-risk-weight status margins. If this happens by any chance, the next crisis will start in the USA (M.N., 2010).
The first step in setting loan rates for new car loans for four years is to analyze the main factors which will determine the rate. Every month each bank sets the ‘prime rate’. The bank almost never grants people with these ‘prime rates’ loans. That is why I will need to determine the risk level on which the client can default and what will be left to the bank in such a case. The risk with car loan is always higher than that for the house, due to the mortgage specifics. That is for my car loan rate must be a little bit higher than the bank’s house mortgage rates.
I should also analyze the situation on the car market critically, so as to establish whether the increase or decrease in buying cars is anticipated for the next four years. On the other hand, I must clarify the financial sides in the Miami bank to be able to determine, which is the lowest loan rate that the bank can afford provide for its clients.
I should not forget to determine whether it is necessary for the bank to demand the down-payments to get a car loan from the clients. The same applies to the trade-ins. If the client has an old car which he can sell and in such a way lower his interest rate, I need to check out whether the Miami bank will accept it.
After investigating the possible changes in the market, I can say that, during the next four years, the amount of cars sold would greatly increase, and the average rates for four year loans can be 4.36 % in Miami-Bank. I can use the following chart to calculate the amount of payment for the potential customer whose car, let us presume, costs $ 25 000, and there is no down-payment or trade-in.

Vehicle Price, $

25 000

Down Payment, $


Trade-In Value, $


Sales Tax, %


Interest Rate, %


Term (Months)


Monthly Payment, $


I would like to say that I do not agree with Mr Hensarling’s statement concerning the Dodd-Frank Wall Street Reform. I considerate the reform to be a successful step towards the improvement of the domestic financial services industry. The aim of the Act was to restore public confidence in the U.S. financial system, prevent possible financial crisis, and allow any asset bubble in the future to be easily detected and eliminated before one more crisis comes.
According to this Act, the governmental authorities are provided with more information, more power, and, most importantly, more funding. The Dodd-Frank Act also extends the sphere of influence of the Federal Reserve beyond the banks. Now the Federal Reserve has the power to supervise all the agencies which are engaged in financial activities.
The useful authority is formed to control and liquidate those financial firms which are in trouble in case their failure can endanger the financial stability of the nation, Orderly Liquidation Authority. This Authority determines on its own those elements which caused risky situations, funding and mechanics of the liquidation process.
For the first time, the regulatory objectives will be to maintain the overall financial stability and mitigate systematic risks. For these objectives to be reached and applied in the financial firms together with nonbank financial institutions, the Financial Stability Oversight Council is established.
This Act also imposes significant new and numerous regulations on banking organizations, as well as allows the Federal Reserve to supervise such companies as investment firms and insurance companies. On this basis, the Consumer Financial Protection Bureau is created to make the supervising process more effective and ensure better services and capital regulations. This Bureau examines certain types of institutions and establishes and enforces rules which are related to consumer financing (Sweet, 2010).
The Dodd-Frank Act also presents some limitations that will make insured depository financial institutions move most of their derivatives to nonbank affiliates (which are also regulated) and to agree with the new support standards and capital.
The Act makes significant changes of the rules that influence the process of financing business enterprises. These changes are conducted in the following areas: securitization, credit rating agencies, swaps clearing houses and derivatives, and investor protection and securities enforcement.
Under the Act, originators of the asset-backed securities will be required to keep at least  5 % of the credit risk related to the securitized assets.
Credit rating agencies enter an entirely innovative regime of regulations under the Act. Substantive standards, private litigation rules, and disclosure obligations are applicable to the rating agencies.
 The Act imposes an innovative regulatory regime upon over-the-counter derivatives including exchange trading, clearing, and other requirements which aim at increasing transparency, efficiency and liquidity, and decreasing systemic risk. Now the mechanisms are established to satisfy these requirements. Their effects on market practices are constantly predicted. The potential for these new regulations is constantly evaluated in order to predict any possible failures. This is done together with the new implementation and supervising responsibilities which carry regulators and help increase the amount of costs of needed swap transactions, produce market dislocations, and also influence some types of investment funds and well-structured finance transactions.
The Dodd-Frank Act expands investor protection mission and SEC’s enforcement program by establishing a whistleblower bounty program and allowing the SEC to establish a “fiduciary duty” on brokers and dealers that give retail investment pieces of advice.
I also find effective the idea of authorization the SEC the adoption of rules by providing nominating shareholders with an access to the proxy of the company. Moreover, the Act demands expanded disclosure of the executive compensation and provides shareholders with the right to ‘say-on-pay’ voting on executive compensation (Sweet, 2010).
To conclude, I would like to add that I see more positive effects of the Dodd-Frank Act Wall Street Reform than negative ones, and I think that it helps, indeed, to keep the situation at least a little bit under control in this hard time of economic crisis, not only for the United Stated but the whole world.
Bank stress testing is a certain analysis which is conducted under not quite favorable economic scenarios. The aim of this analysis is to detect whether banks have enough capital to resist the influence of the unfavorable developments. Such tests can be either performed by the banks internally (as a part of the banks’ risk management) or by a corresponding authority (as a part of its regulatory supervision of banks). Bank stress tests help to find out defects of the banking system at any given stage, therefore, regulators can make preventive test so as to protect the future of the banks.
One of the main disadvantages and limitations of the financial institutions’ stress testing is possible test failures, which may damage not only confidence but create serious problems, which the test was designed to avoid. The exercise can cause the over-cautiousness; that is the banks may freeze the capital, which, in other cases, can be profitably invested. Unfortunately, the mathematical model is developed on quite many assumptions, which can appear to be wrong one time.
In my point of view, there is a slight need to promote efficiency and flexibility of the stress testing process. A standardized framework could provide many more benefits. Those tests, which we have now, can still omit too many crucial details, that is, make wrong calculations, and the circumstances would be terrible. Banking system develops all the time, no wonder that the ‘tools’ which are used in it, must be always upgraded, too.
Creating such flexible stress testing the possibility within a financial institution could drastically reduce the manual overwork costs involved in building temporary stress tests. Regulators and banks could obtain the benefits from the best practices and access to expertise, shared research and learning.
I understand that a swap is designed to transfer the credit exposure of products with fixed income between parties. A credit default swap can also be referred as a credit derivative contract, in which the buyer of the swap pays up until the maturities of a contract. Payments are transferred to the seller of the swap. The seller can agree to pay off a debt of third party if such a party defaults on the loan. A credit default swap is regarded as insurance against non-payment. A purchaser of a credit default swap can speculate on a possibility that the third party may default (Pinsent, 2008).
Nowadays, credit default swaps are considered to be the most widely used credit derivative. The power of the credit default swaps in the world markets is immense.
A credit default swap contract involves the credit risk transfer of corporate debt, municipal bonds, mortgage-backed securities, and emerging market bonds between two parties. Credit default swap is similar to insurance as it provides the purchaser of the contract often possessing the underlying credit, credit rating downgrade, with default protection, or some other negative credit. Sellers of the contract assume the credit risk that purchasers do not wish to bear in exchange for a temporary protection fee which is like an insurance premium, and who is obliged to pay only in case if a negative credit comes out. We have to remember that the credit default swap contract is not bonded but references it. Because of this, the bond, which is involved into the transaction, is the reference obligation. One contract may reference multiple credits or one credit.
As I mentioned above, the purchaser of a credit default swap earns a profit or gains protection, and this depends on the goal of the transaction, when the issuer come out with a negative credit event. In such a case, the party that has sold its credit protection, but who has recognized the credit risk, has to deliver the value of interest and principal payments which could have been paid by the reference bond to the protection purchaser. In the case, when the reference bonds still have a certain degree of the depressed residual value, in turn, a protection purchaser must deliver the current cash value of these referenced bonds; or he or she can deliver the actual bonds to a protection seller. This balance depends on terms, which were agreed upon at the signing of the contract. If no credit event is available, the seller of protection obtains that periodic fee from the purchaser. He or she can also get profits if the debt of a reference entity remains useful during the lifetime of the contract and there is no place for payoff. The contract seller, however, takes the substantial risk of massive losses in case the credit event takes place.
Credit default swaps have two following types of application (Pinsent, 2008):
1)    A credit default swap contract can be applied as an insurance policy or a hedge against the default of a loan or a bond. A company or an individual that is under a lot of credit risk may change some of the risk by purchasing protection in a credit default swap contract. It can be better than purchasing the security when the investor wishes to decrease exposure, however, not liquidate it, eliminate exposure for some time and avoid undertaking a tax hit.
2)    The second use is to give the speculators an exceptional opportunity to make their bets of the credit quality concerning some certain reference entity. With the larger than loans and bonds value of the credit default swap market, it becomes obvious that such speculations have grown to perform the most ordinary function for a credit default swap contract. Credit default swap provides a highly effective way to regard a credit of the reference entity. The investor, who has a positive view onto the credit quality of one certain company, may collect the payments and sell protection rather than waste lots of money to upload on the bonds of a company. The investor, who regards the credit of the company in a negative way, may purchase protection for a comparatively small periodic fee and then obtain a large payoff, when the company defaults on its own bonds or has another credit event. A credit default swap may also become a way to reach maturity exposures, which otherwise would not be available, make investments in foreign credits without any currency risk and reach credit risk at that time when the bonds supply is limited.
Unfortunately, the market for the credit default swaps is highly unregulated, and because of this, contracts often are traded so much that after it is difficult to understand who is responsible for each part of the transaction. The possibility exists that the risk purchaser may lose the financial strength to keep up with the contract's provisions, causing difficulties in valuing the contracts. A certain leverage engaged in many credit default swap transactions, and the likelihood that an expanding downturn of the market could make enormous defaults and even challenge the opportunity of risk purchasers to make the needed payments, only adds up to this uncertainty.
Between 2000 and 2008, the swaps market went from $900 billion to over $30 trillion. In contrast to traditional insurance, credit default swaps are entirely unregulated. That is the reason, why they played a key role in the world’s financial recession, in the end of 2008 (Credit Default Swaps, 2012).
The Dodd-Frank financial, regulatory reform bill issued in 2010 offered to create new derivative clearinghouses. I consider this to be a favorable way to try to regulate credit default swaps at least somehow in order to avoid the same meltdown as in 2008.
Some economists expressed their concern that, if no credit event would be triggered, it would harm the credit default swap market, as when borrowers are able to structure defaults to omit swaps paying-out, investors can regard swaps as unreliable anymore (Credit Default Swaps, 2012).
The initial purpose of the swaps was to help banks to create complex debt securities while reducing the risk to buyers, so I hope that this purpose would come to be actual again in the near future.
Value at risk is a technique which is used to evaluate the potential losses. This technique is based on the statistical analysis of volatilities and trends on historical price. Value at risk is usually used by security firms, companies, and banks which are involved in the trading activities. Its main use is to calculate the possible risk, and it is favourable to apply when companies make hedging decisions and trade.
The concept of Value at risk helps financial institutions manage interest rate risk and to see it clearer, let us have a look at the example of measuring time in trading days.
The value at risk concept has a number of practical disadvantages and advantages. Let us ponder over them according to the Center of Financial Education (Advantages and Limitations of Value at Risk (VaR), n.d.).
Advantages are: calculation of potential losses using clear terms; approved by different regulatory authorities concerned with the risks which financial institutions face; versatility.
Limitations include: evaluation difficulties, sensitivity to evaluation techniques; probability of creation a false sense of safety; tendency towards underestimation of worst-case results; the value at risk of a certain position does not always interpret well into the value at risk of the whole portfolio; failure to combine positive results, therefore, an incomplete picture is depicted.
I can understand much better now why a value at risk is such a popular means of assessment in financial service companies, in which assets are the marketable securities, and limited capital is at play, as well as regulator which outlines the temporary exposure to significant risks. What we should not forget is that the value at risk can be applied only to the special non-financial servicing companies.

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